On the Optimality of Capacity Regulation in Competitive and Price-Capped Electricity Markets

The liberalization policies in the eighties and in the nineties governed the transition to market competition in the electricity sector of many countries. However, many of these markets experienced a wave of capacity-related regulatory reforms, driven by a growing concern regarding the capacity underinvestment or "missing money" problem that arises in the presence of price caps. These experiences posit the fundamental question of whether capacity regulation is desirable in competitive and price-capped electricity markets. Using a two-stage framework, in which cost-heterogeneous generators invest in capacity and then serve consumers, we show that the competitive market fails to achieve the efficient outcome in the presence of a price cap. We show that, in this market, a regulatory framework in which the regulator sets a mandatory level of capacity while generators that invest in capacity receive a capacity compensation payment restores market efficiency, and it also reduces price volatility